I am president and chief market strategist of InterMarket Forecasting, Inc., a research and forecasting firm that quantifies market-price signals to guide the asset allocation and trading strategies of pensions, banks, investment managers, and hedge funds. I have authored two books and six chapters on money, banking, economics and public policy. My work has appeared in Forbes, the Wall Street Journal, the Economist, Investor’s Business Daily, Barron’s and the New York Times. I am also a contributing editor at The Objective Standard. I have worked previously for the Bank of New York, Citicorp and H.C. Wainwright Economics. I earned my B.A from Bowdoin College, my M.B.A. from New York University and my Ph.D from Duke University.

The Lopsided Fiscal Cliff Deal: All Tax Hikes, No Spending Restraint

Speaker of the House John Boehner (R-OH) (Image credit: Getty Images via @daylife)

Republicans were just rolled – yet again. Throughout the 2012 presidential campaign, and up until New Year’s Eve, President Barack Obama kept insisting that any solution to the U.S. “fiscal cliff” required what he called a “balanced approach” — meaning that forthcoming federal budget deficits should be narrowed partly by tax hikes (on “millionaires and billionaires”) and partly by spending restraints. Of course, we all know that Mr. Obama and the Democrats wanted only tax hikes, while the Republicans mainly wanted only spending restraint.

In the November election, we know Democrats won the White House, while the GOP won the House of Representatives. Thus a “balanced” result seemed justified. But instead, the so-called “fiscal cliff” deal that was struck last week in Washington, approved by the Senate (89-8) and House (257-167) alike, was lopsided: it entails all tax hikes (on the rich and middle class alike) and no spending restraint.

How can this be? The U.S. Constitution gives the House of Representatives the primary and plenary power to raise taxes and spend money; thus the GOP-controlled Congress, not Mr. Obama or even the Democrat-controlled Senate, deserves the main blame for what just happened. The GOP, as usual, caved under pressure; just as many GOP leaders refused to fully back Mr. Romney in last year’s presidential campaign, now, even after the election, they’ve refused to take seriously the fact that they handily re-won the House.

The GOP has also refused to take seriously what their rival – Mr. Obama – conceded himself, in a July 21, 2011 op-ed in USA Today (“Go Big on Debt Deal”), when he wrote: “For years now, America has been spending more money than we take in. The result is that we have too much debt on our nation’s credit card, debt that will ultimately weaken our economy [and] lead to higher interest rates for all Americans. . . . Every day, families are figuring out how to stretch their paychecks a little further, sacrifice what they can’t afford, and budget only for what’s truly important. It’s time for Washington to do the same. . . . I’ve also said that I’m willing to cut historic amounts of spending in order to reduce our long-term deficits. I’m willing to cut spending on domestic programs to the lowest level in half a century.” So unless the president was lying in his USA Today op-ed, he was saying he’d be willing to cut federal spending by historic (large) amounts, to the lowest level since 1961(!), yet the GOP today isn’t willing to take his radical offer. Mitt Romney had proposed cutting the spending share of GDP from 25% to 20% (it was only 18% of GDP in 1961), but GOP rivals opposed him as a “big government” guy, which only helped Obama win re-election last fall; now GOP congressional leaders won’t take what Obama once pledged to give them on spending.

The GOP majority in the House should have demanded spending restraint as part of the recent fiscal deal, even if that meant steep and automatic “sequester” cuts at the Pentagon; but the GOP remains heavily influenced by war-mongering neo-conservatives. Even if spending restraint wasn’t possible, the GOP should have opposed tax discrimination; taxes should not go up for anyone, but if they are to rise for some, they should rise for all. The rich should not be treated as second-class citizens. Mr. Obama has long claimed that the American rich don’t pay their “fair share” in taxes; in fact, the top 1% of income earners generate 17% of all personal income but pay 37% of all U.S. federal income taxes, while the lower 50% of earners pay just 4% of them. The rich pay far more than their fair share, and now Obama (who was electorally-favored by the rich, winning 80% of the nation’s ten richest counties) will try to exploit the rich still more, with the help of the GOP. GOP leaders should be refuting, not embracing class-welfare rhetoric and policies; but the GOP remains dominated by Christians suspicious of capitalism and by ardent lovers of the welfare state.

Supporters of Mr. Obama’s envy-oriented tax hikes on the rich (up from 35% to 39.6% on ordinary incomes above $400,000, and up from 15% to 23.8% on investment income) like to insist that the higher tax rates should not prove bearish for the economy or investment, because the rates merely mirror those that were in place during the prosperous Clinton years (1993-2000). The important context they drop is that government spending was restrained in those years, to the point where budget surpluses totaling US$560 billion were generated over four consecutive years (1998, 1999, 2000 and 2001). That wasn’t due to revenue gains. Federal spending declined from 22.1% of GDP in 1991 to 18.0% of GDP in 2000; the ratio averaged 19.5% in Clinton’s two terms. Under George W. Bush this spending ratio climbed from 18.0% (2000) to 20.8% (2008); it has averaged 23.9% under Obama and will average close to 22% in his second term (2013-16).

Most economists are breathing a sigh of relief these days that a lethal “plunge” over the “fiscal cliff” was averted, because they falsely believe government spending restraint harms output; in fact, such restraint is bullish. History shows that the real burden of government on the economy is its overall spending, not the manner in which its outlays are financed (although an economy is slightly less-burdened, for any given level of spending, by debt financing than by tax financing). Contrary to the usual (Keynesian) interpretations, the fiscal deal that was just struck in Washington was the worst of all possible outcomes: bearish tax hikes plus bearish spending increases. Tax cuts and spending cuts would have had the most bullish consequences (other combinations were neutral). There’s no such thing as a Keynesian “multiplier,” whereby a dollar spent by politicians magically boosts production by more than a dollar; if anything, there is a government spending divisor. At the extreme, socialism means the state spends 100% of GDP. Has that proved bullish?

Thankfully, when it comes to cyclical patterns, monetary policy tends to over-power fiscal (and regulatory) policy, so as bad as the latest fiscal deal may be, it won’t cause a recession in 2013. As long as the U.S. Treasury yield curve is upward-sloping (as it now is, and will remain in 2013) – and in the context of a zero-short-term rate, as long as the spread between the 30-year and 10-year T-Bond yields remains wide (more than 100 basis points) – the signal is for decent growth. Only an inverted yield curve would signal recession. But this is not to deny that the Fed’s policy will keep causing economic stagnation and persistent inflation.

The fiscal disease in America is excessive government spending and an unsustainable welfare state, not insufficient taxing – a fact ignored by the fiscal deal-makers. A majority of American voters have revealed that they simultaneously want European-style state spending (high) and American-style government taxing (low), which means they want budget deficits and rising public debt, even while claiming to oppose them. We might say they “want their cake and eat it, too,” but in truth they want government to help them eat the cakes produced by others, while hoping (or even expecting) the exploited won’t eventually quit their baking.

Most American intellectuals and U.S. politicians are hoping Americans will get used to permanently-higher government spending as a share of GDP, and eventually, higher tax burdens, if even on the middle class (as exist in the dysfunctional European welfare states). Until then, electorally-rewarded U.S. politicians will keep deficit-spending and borrowing at cheap interest rates, thanks to the Fed’s debt monetization schemes. Government will keep hogging scarce savings. But as Japan amply demonstrates, in recent decades, such a policy of persistently-low interest rates and rank money-printing only brings long-term economic stagnation.

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